Wednesday, February 11, 2009

Rationality and Darwin

In today's Wall Street Journal I read yet another article talking Darwin and about how people are not rational. This growing field in behavioral economics argues persuasively that we should question our economic foundations based on the assumption of a rational actor.

I have no disagreement over the fact that people are not perfectly rational, we aren't. I concede. What I don't concede are the implications of this fact. The logic advocated is that if people are not rational then we must not trust their judgements and hence the free market system which is based on the fact that people make rational judgements cannot be trusted.

The problem with that argument is the confusion of actions with their reprecussions. If we or anyone were omniscient and infallible, then no mistaken actions would take place. This is obliviously not true, we can and often do make mistakes. Here is the important point: do we accept the fact that we WILL make mistakes? If you believe that mistakes are inevitable then the really important question is how to mitigate their impact. The feedback mechanism for communicating our mistakes is essential to prevent a recession from becoming another depression.

I am reading this George Soros book that refers to booms and busts in the economy. He creates a theory of reflexivity in which feedback loops change our underlying behavior. The idea is that we don't act rationally and that our irrationality builds on itself until it is no longer sustainable. This feedback initially creates a boom followed by an inevitable bust and the process repeats.

What I think Mr. Soros laments is the fact that our irrationality causes these booms and busts and that because we know these are irrational we should somehow prevent them. The problem with his argument is the notion that in one context we have the ability to act rational while his entire argument is based on the notion that we are irrational. No system can take away our irrationality and mistaken actions. Whether administered by a beareaucrat or by the market mistakes WILL be made.

Those on the market side of things are making a mistake when they argue that the market is perfectly rational. The purpose of the market is not to prevent mistakes but to punish mistakes. The more efficiently we let that happen the better off we will all be.


Post a Comment